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Calix Inc. (NYSE:CALX)

Morgan Stanley Technology, Media & Telecom Conference Transcript

February 25, 2013 3:45 PM ET

Executives

Michael Ashby - Chief Financial Officer

Analysts

Jeremy David - Morgan Stanley

Jeremy David - Morgan Stanley

Good afternoon, everyone. Welcome to the Calix’s Presentation. My name is Jeremy David. I’ve -- I’m a member of the Communications and Equipment team here at Morgan Stanley working with Ehud Gelblum. Ehud apologized he is not able to be here today with us. Today we have from Calix, Michael Ashby, CFO. Mike welcome. I have a few disclaimers to read in personally but that’s very short before we get started.

Please note that all important disclosures including personal holdings disclosures and Morgan Stanley disclosures appear on the Morgan Stanley public website at www.morganstanley.com/researchdisclosures or you can get them at the registration desk as well.

So let’s get started with the Q&A. And Calix grew up as a U.S. company, but you really focus on expanding internationally now. You’ve done that organically and more recently you have an agreement with Ericsson. So last quarter the picture was mix, the organic part of the international business did well, Ericsson didn’t do that well. So we’ll first talk little bit about Ericsson and understand why the business underperformed, didn’t meet your expectations and when did you realize that there was a problem with the Ericsson give us view of business?

Michael Ashby

We had an agreement with Ericsson announced actually in November of 2012. It is a two part agreement, one is to resell a product that we bought from them the BLM 1500 back to Ericsson and then secondly, a global reseller agreement.

And for the BLM 1500 had been running between $10 million and $15 million a quarter run rate. And we naively assumed that it will continue at the same run rate, actually reduced our expectations for Q4 since it was abbreviated quarter and the reality was we hadn’t realize was then Ericsson shipped a lot of those customers as much product as they could before the deal closed, so there wasn't much left at that point.

And then it taken us a while to figure out how to work with Ericsson, so we realize almost immediately that this going to take longer than we thought, it’s a large complex company, and then just trying to move things through that company is being quite tough us, for instance it us take three months just to get a process in place, how to translate orders from Ericsson back to us.

And we’ve also had to go out and start meeting with the customers, the Ericsson Tier 1 international customers and the Ericsson’s sales regions, introduce ourselves to them and show the customers that the BLM 1500 is not finished, it’s not end of life. It’s in fact going to have a future and we going to continue development on that.

We are trying to work with Ericsson and to do that we are hiring some people to help manage that channel, people who have experience of working with Ericsson in the past, who know the right people to talk to, the right way to get through that organization. So we are not concern longer term about the business, but in short-term it’s going to take us two or three quarters to start to see that ramp up.

But just little bit more detail there. The deal is really about a reseller agreement with them; not about reselling BLM 1500. The objective of the deal is for us to be able to resell our E-Series products through Ericsson globally.

In order to do that we have to interface our products with the Ericsson operating system and that work is ongoing at the present moment. It’s going to take two to three quarters before that is finished, because there is a lot of testing involve in doing that. Once we can do that than we can start reselling our E-Series products back through Ericsson internationally, and that’s the objective of the exercise and we are well underway done that path. We are developing the interface with their products, once that is happened, which will be second half of 2013, we think we are going to have some considerable opportunities out there.

Jeremy David - Morgan Stanley

But the next milestone is really two or three quarters away both the BLM 1500 ramping back to its quarterly run rate $10 million, $15 million and E-Series being shipped internationally through it?

Michael Ashby

That’s correct. And we are starting to see the BLM pick up. It’s not $10 million to $15 million yet, but we are beginning to see that pipeline pick up as we visit the customers, we start to see what’s out there.

And there are 2500 chassis of the BLM 1500 installed internationally and so those all require being supported and upgraded as time goes on. So that business is going to come back it’s just a question of time.

Jeremy David - Morgan Stanley

Okay, and in the interim, you mentioned customers had BLM on hand. If they actually want to order one today, can the order be fulfilled through you and Ericsson?

Michael Ashby

Yeah. It can.

Jeremy David - Morgan Stanley

It can.

Michael Ashby

It can.

Jeremy David - Morgan Stanley

So there is no risk for the customer migrating to competitors?

Michael Ashby

No longer the risk, we’ve not figured out how to get the order from Ericsson through to us and Ericsson actually manufactured that product through Flextronics, and it’s the same contract manufacturer, we use that in the seamless transition and so we are now able to ship that product directly.

Jeremy David - Morgan Stanley

Okay. Great. Organically, you’ve expanding internationally as well and that -- last quarter as part of your international business was strong, I think surprised investors and surprised us. Is that growth sustainable, is that just kind of one quarter lumpiness deals or is it sustainable momentum that you are also seeing and where is that international business, where is it today?

Michael Ashby

It’s a little bit of both. We are fairly strong in Canada and Caribbean having for some time and that business can be a little lumpy because you tend to get large orders, but nevertheless we do see lot of opportunity in both of those regions going through the next year or two.

And we are also building up Tier 2 and Tier 3 business internationally in other parts of the world; and we have put into place over the last 18 months that infrastructure of people and signed up resellers in different countries, and we are beginning to see that increase every quarter bigger than previous quarter, and I believe we have something like 20 new customers in 2012, all that start into small dollar but beginning to grow and we expect that to continue to grow. So as to where that opportunity is, it is primarily in developing countries not in developed countries.

We’re going after the Tier 2 and Tier 3 accounts in those countries where they tend to want to move quickly to invest in fiber as opposed to developed countries where they are prolonging the life of copper as much as they can. So our opportunities tend to be in places like Eastern Europe, the smaller countries in Asia, Middle East, Africa and South America.

Jeremy David - Morgan Stanley

I know that you, you've had this channel that you've built already, or that you're in the process of building, and you have Ericsson. How do the two work together, are they complementary?

Michael Ashby

They actually complement each other perfectly because our own infrastructure is for Tier 2 and Tier 3 service providers internationally. Ericsson is almost exclusively for Tier 1 international service providers. Interestingly, that’s in the developing countries, not in the developed countries.

And so the two fit together on top of each other perfectly. And as I said what we are doing to propose the management is putting the channel management strategy in place to be able to manage that channel. And it fits right on top of the Tier 2 and Tier 3 in infrastructure that we already have in place.

Jeremy David - Morgan Stanley

Great, last question on the international before we move on to your bigger domestic business. How much do you need more to expand your capabilities internationally outside of Ericsson, as you go towards the smaller Tier 2 and 3, I imagine there's a lot of professional services that you need to be able to deliver. Do you have the capabilities today, do you need to invest more, or have you already made the investments to get these bigger deals done?

Michael Ashby

We’ve actually already made most of the investment. We have people in place in various parts of the world now. We’ve expanded our value-added resellers. And generally speaking, the value-added resellers are one who does the professional service. So that’s a part of the contract that we have with them. And so there is very little additional investment that we have to make except as the business grows, obviously we’ll continue to invest more.

But to build it, there is very little additional we have to do. The major investment we’re making at the moment is in channel management with Ericsson who are hiring some people to work with us, sales, regions and manage the Ericsson partnership at a high level.

Jeremy David - Morgan Stanley

Okay. Great. That’s helpful. So domestically, that business has done very well last quarter. There was a lot of trends. You’ve actually got Q1 to be flat or flattish and typically Q1 is down about 20% more or less sequentially. So where is the upside coming from in the short term? Are you spending at regional Tier 3s? Is that Qwest? Is that Frontier? Is it something else? Can you help us quantify the drivers and which one has the most important one?

Michael Ashby

Indeed. Our business actually over the last couple of quarters has been strong across the board, not on any particular area and has been picking up. And as you know in Q2 of 2012, we had a big miss because of the regional accounts slowed down. And we have started to see those regional accounts begin to invest again and begin to build back up. And we expect that to continue over the next few quarters.

But there is no one part of the business that has really been much stronger than another. So when we look at 2013, there are really five growth areas that we’ve identified. The first one is the legacy Qwest property within CenturyLink whereas I think you know we received final internal Qwest IT certification in December, actually end of November 2012. So we were able to ship in December and we’re continuing to ship into the legacy Qwest properties within CenturyLink. And we’re able to compete now in the entire CenturyLink portfolio, which is -- and if you remember Qwest, it’s actually twice the size of the CenturyLink -- of the original CenturyLink. So it’s a large opportunity for us. Therefore now we’re able to compete and we’re starting to see some success in that area of the market.

The second area that we can compete in, have been for the last two quarters is in the Verizon states acquired by Frontier. And those states were converted on Frontier operating systems throughout the middle of 2012. And so we’ve been able to compete now in those states and again having some success in that business as well.

And third area as I mentioned is the new regional account that are beginning to invest again. They dropped dramatically in Q2, stabilized a bit in Q3, started to come back in Q4. We expect that to continue over the next couple of quarters and then to get back to more normal trajectory in 2013 and ‘14.

And then we have the two international arms that we just spoke about the Tier 2 and Tier 3 while building our own infrastructure which is ramping up albeit from a slow base but nevertheless each quarter is larger than previous quarter. And that will continue to grow.

And then on top of that is the Ericsson reseller agreement. So those five areas are the ones that we are concentrating on in 2013 and 2014. And if I was to rank those in order of priority within 2013, it is primarily the domestic opportunities: the CenturyLink-Qwest, the Frontier-Verizon states and the regional will allow us to grow in 2013 and then as we get to 2014: international portion -- the international expansion in the Ericsson agreement become more important to us.

Jeremy David - Morgan Stanley

Okay. So if I look at your guidance or if I look at the street numbers and you kind of said those numbers seem reasonable. That implies that most of that growth which is north of 20% is actually really driven by domestic opportunities you are going after and that really Ericsson and Tier 2 and 3 internationally that’s been going after organically, that’s additional to that which really initially embed that?

Michael Ashby

Well, that’s both the international Tier 2 and Tier 3 and Ericsson will grow in 2013 but there is a very small base. So the largest -- the largest portion of growth is from the domestic opportunities, the Qwest, the Frontier Verizon and the regional, that’s true.

Jeremy David - Morgan Stanley

So let’s talk a little bit about Qwest because that’s really where some of growth came last quarter. You started -- just started shipping in December as you’ve said. I think it’s about 11 million lines total that’s size of the opportunity. How many of these lines could be upgraded over the next four years and how much revenue could that potentially mean for you on a per line basis or if we look at the total opportunities that you can go after?

Michael Ashby

It’s difficult to quantify and perhaps the best way to look at it is to say that the Qwest CenturyLink combined spent around $240 million a year on access. So that is an available market to us. The CenturyLink portion of that, the historical portion of that was obviously relatively smaller. But the Qwest portion was the larger product. And so we now compete in both sides.

It’s difficult to say precisely where we compete because what’s happening is that CenturyLink looking at their projects and rolling out projects, project by project, region by region within CenturyLink legacy and within the legacy Qwest territories and as CenturyLink moves more towards -- pushing the fiber deep into networks then we have more of an opportunity to compete and more of a competitive advantage.

So we really are driven by the vision that the future networks will be all fiber and while we support the transformation that works from copper to fiber, we believe that it’s necessary for service providers to push fiber deep and deep into the network. We’re starting to see that happen in number of service providers with CenturyLink-Qwest is one of them.

But what is driving our market to a large extent and driving the overall growth in the market is the competition that we’re seeing from other service providers and cable advertising a 100 megabit per second to the home using DOCSIS 3.0, what we call disruptive service providers coming in such as Google in Kansas City, other municipalities are the disruptive service providers that are begin to talk about and offer a gigabit per second to the home.

You can’t get through their speeds through copper. You have to move to fiber and you have to move to fiber pushing fiber deep within the network of fiber all the way to the home. So with that competitive environment, which is heating up, which is pushing service providers, I think start to invest more, and they look at fiber so that becomes competitive advantage for us.

Jeremy David - Morgan Stanley

Okay. Can you mention that CenturyLink key is extending that Prism TV offering which is an IPTV offering into the Qwest account. Does that help you at all? Is that a driver, is that -- do they need to upgrade products to be able to build their network?

Michael Ashby

Yeah. CenturyLink has a product called Prism TV, which they’ve been quite successful in their legacy territory. And they have announced that they want to roll it out into different parts of the Qwest network and that is large part of that runs on Calix equipment. So they will let out but certainly in area that we can compete in.

As they move more and more to upgrade the network overall and deeper -- pushing fiber deeper and deeper into network then I would say that’s an area where we start to compete and start to have some other advantages.

Jeremy David - Morgan Stanley

Okay. Great. As you mentioned at Qwest, you’re really competing on a project-by-project basis. Can you give us a flavor for who you are competing with or who you are seeing in the RFPs and through what extend you can, give some color on win rates or expectation for win rates going forward?

Michael Ashby

Okay. There aren’t really RFPs, but there are RFP projects that are put forward and that are examined different vendors. Generally speaking I think you know Qwest was the 100% ADTRAN until December of 2012. So our competition in that part of the territory is ADTRAN and in most of CenturyLink it is ourselves and ADTRAN, and I think we’ve said this before, over the last three years in the CenturyLink legacy network there have been two access suppliers, ADTRAN and ourselves, and we had approximately 60% and ADTRAN 40%, that hasn’t changed very much. ADTRAN had 100% of Qwest and now we are competing in that larger territory and will be able to compete project by project and hopefully gain some share overtime in those areas. So that’s sort of the situation as far as CenturyLink is concerned.

In other markets, we compete primarily in North America against Adtran. There are some other smaller competitors every now and then that we come up against. We don't see Alcatel Lucent that much directly in competitive situations. They are obviously the big supplier to the large Tier 1s, to AT&T and Verizon, but we don't see them that frequently going further down. And internationally we do see Huawei as the biggest competitor, and Huawei and Alcatel Lucent are the two largest competitors that we have internationally.

Jeremy David - Morgan Stanley

You mentioned, expanding on my question, beyond Qwest. So, let's talk about the other big opportunity you have as well with Frontier and the Verizon lines. How should we think of that opportunity versus Qwest, is it both in terms of size, of timing, of your competitive position there and assuming Adtran is at Frontier, but how can you actually frame two different opportunities for you?

Michael Ashby

Frontier is very similar to Qwest in that it is a similar situation where they were buying for the Verizon lines exclusively from Adtran up until the middle of last year, and now we're able to compete and they are also rolling out different projects, looking at pushing fiber into the network and whenever they start doing that again we are able to compete in those situations. And we're seeing that happen. It's a much smaller opportunity than Qwest of course, and the reason why we talk about the Qwest opportunity and the Frontier-Verizon opportunity is because those are market expansion areas for us. So, that we weren't able to compete in those. We can, now. Therefore, they represent market expansion to us.

Within other Tier 2 accounts in North America, the business is also reasonably good and if you look at the CapEx environment some of those territory accounts are increasing CapEx, some are cutting CapEx, some off in 2013, but it’s a pretty healthy environment overall in North America.

Jeremy David - Morgan Stanley

Okay, and so let's talk a little bit about the Tier 3s, as well, where the trend seems to turn around with more orders and more project activity. How is the regulatory environment changing, is that, I think the FCC was supposed to issue an order telling carriers what formulas they should use to compute the regional investments, and I think it was any day we would see it, and if not, when shall we expect it? And is that really what's driving investment by the Tier 3s?

Michael Ashby

You know, what has, the other way to look at it is what held back investment by the Tier 3s was the regulatory uncertainty, and the fact that they didn't know where this was going to end up. So, in January of 2012, the FCC announced the movement of the traditional voice subsidy to a broadband subsidy. It totals $4 billion a year which is not a tax, it is what we all pay on our telephone bills, which has supported the rollout of voice in rural United States for the last 75 years.

That's now moved to a broadband subsidy. When they first announced that, they announced in April, they issued the first rules as to how they were going to apportion that, and the regional accounts in general, most of them were worse off under the new rules. So, they stopped spending and started fighting the FCC to try and get changes made.

There have been a number of changes made. They actually took the FCC to court on three different occasions, lost each one of them, but over the period of time the FCC has come out with slightly different regulations. And in the beginning of February the FCC actually adopted final regulations which they are due to publish at any point in time. Any day, literally.

And at a recent regional telephone conference in Orlando, Florida, where there is now one regional association for all of these regional telephone companies, the FCC actually gave a speech there and they outlined some of the things that they've agreed to. And generally speaking, those are slightly more positive than had been expected.

So, we had a team of people down at that conference and they came back and their reports to us were that the atmosphere was a lot more upbeat this year than last year, that they're seeing some regional service providers talking about starting to invest, others talking about investing, and they are simply waiting for this actual order to be published and then it is a final order so then there won't be any changes after that.

And so, that's why we see the regulatory environment actually clarifying itself, and we have started to see investment beginning again. We expect that to continue for the next couple of quarters to get back to where it was, and then to continue thereafter in the normal trajectory.

Jeremy David - Morgan Stanley

So should we see a step up in orders when the order is finally released, or just gradual increase?

Michael Ashby

Well, unfortunately what happens in our industry is that, you don’t; there isn’t such a thing as pent-up demand because they can only roll out one project at the time. So its not that they have project that put on hold they can then start doing much project, while they do have, they start working on this projects again.

So, no, there is no big catch up or pent up demand. What there is, there is a slow increase in CapEx as they begin to invest again. And the timing of course that is quite good with the final order coming right now, because this is get to us bring at the time when they regional start to build and so we do expect to see that order flow continue to increase slowly quarter-on-quarter through 2013.

Jeremy David - Morgan Stanley

Great. So, it looks like it great start up for you this year, with domestic business really ramping on different avenues of growth and international kicking as well. So I think you’ve, you said, you want to maintain OpEx relatively stable for the topline through the year, so should we see operating margin expand from flattish in Q1 to maybe double-digit in the year is that something possible you can achieve or and should that be a gradual ramp over the year?

Michael Ashby

Yeah. That’s good question. Our challenge in 2013 and our execution in 2013 is to grow the top line and we've talked about the opportunities we have to be able to do that. To continue to grow the gross margin, and we've done that for the last three years. We expect to be able to continue to slowly improve gross margin as we go through 2013. I think we've been open about the fact that our target is to get to gross margin with a 5 in front. We expect that to happen over the next three to five years, and so well, we expect to see improvement in 2013. That improvement by the way comes from our product mix primarily, as we sell more of our E-series products. And our plan is to hold operating expenses relatively flat. There will be slight increases, but minimal increases. And so we start to produce some decent leverage as we go through the year, and by the end of the year I think this -- it's our objective to be quite profitable, so yeah, we believe that each quarter will be better than the previous quarter as we go through the 2013.

And then as I said, as we look at 2014, we’re looking at the international opportunities beginning to ramp up at that point and hope we will be able to continue on our expansion from then.

Jeremy David - Morgan Stanley

I want to see there are any questions in the room. Yeah?

Question-and-Answer Session

Unidentified Analyst

I have two questions.

Jeremy David - Morgan Stanley

Okay.

Unidentified Analyst

Question number one is the product that you bought from Ericsson. Is there an upgrade to that product in the work that customers will be compelled to buy and when will that be ready?

Michael Ashby

There is ongoing development that will be done on that product. So there is a roadmap for the BLM 1500 which we are in the process of going out and talking to customers and explaining to them. So that they realize the product doesn’t just end. So there will be ongoing development in that product over the next few years.

Unidentified Analyst

But is there a specific upgrade that is going to be ready in the next year or so.

Michael Ashby

There is no specific upgrade that I can talk about but there is a feature enhancement, technology enhancements and feature enhancements, which are part of the normal course of business. And the customer fear obviously when we acquire that would stop and so we are now trying to explain to them that will stop. We will in fact continue to do that.

Unidentified Analyst

And secondly, the cable operators as you mentioned earlier are talking a lot about bringing Internet to businesses as well as homes. Do you compete in that space? I mean you know, you need a DOCSIS-based interface, or something else to compete, do you have customers in the cable space?

Michael Ashby

We do actually compete in that space and one of our larger customers is in fact Cox Cable. And we sell to Cox Cable for business services, not for residential. And that’s because they have fiber networks, actually GPON fiber networks that they put in for business.

We are also seeing cable companies looking at building fiber elsewhere; for example Rogers, Rogers cable has an RFP out there for an all-fiber network, GPON fiber network. So, we are seeing cable companies move more towards fiber and it is our view that the networks of the future are all IP over Ethernet over fiber, and that those are done by service providers be they cable or telephone companies, regardless.

Unidentified Analyst

And those are all opportunities for Calix?

Michael Ashby

They are all opportunities for us, exactly yeah. So we are -- obviously GPON is something that we are more than familiar with. We also have to be able to interface with DOCSIS 3.0 but that’s relatively easy thing to do. And then we’re able to compete in places where cable is rolling out fiber.

Unidentified Analyst

Is there any low hanging fruit that cable internationally or domestic?

Michael Ashby

Right now. It’s more domestic than international with exception of Canada but then we are seeing more of that happening in North America than we are internationally at the present moment.

Unidentified Analyst

What is the E-Series opportunity at Ericsson -- what is the size of that in relation to the BLM opportunity?

Michael Ashby

The E-Series opportunity is difficult to quantify. It is everything from zero to huge. I’m sorry to give you such a wide range, but point is that if we are successful in selling E-Series through Ericsson then it has the potential to be very large. And it’s difficult to quantify what it would be today but they are installed in 100s of international customers. If we’re able to sell E-Series successful through them than it has the potential to become a very large number. I’m sorry to have been more precise than that.

Jeremy David - Morgan Stanley

Okay. Thank you everyone. I think we are out of time. Thanks for coming. Thanks.

Michael Ashby

Okay. Thank you very much.

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